Greek Target-2 liabilities rise again

More volatility in store

by Frank Westermann

Mon 2 Mar 2015

One of the best indications of stress in economic and monetary union is the evolution of the Target-2 balances measuring asset and liabilities, vis-a-vis the European Central Bank, of the individual euro area central banks. Over the past two years, as a result of a general diminution of tension, these balances have been declining.

Over the past month, as a result of political turbulence in Athens and fresh worries surrounding Greece’s long-term membership of the euro, divergence has re-emerged. The Bundesbank reported a €54bn increase in Target-2 assets to €515bn at end-January. Greece has stated its liabilities increased €26.7bn to €76bn. The volatility of these balances is likely to rise further in coming months.

It is important to look at the trends behind the numbers. In December 2011 the ECB calmed financial markets by issuing two ‘long term refinancing operations’ available to banks for a three-year period, at low interest rates and with reduced collateral standards. This instrument caused a substantial increase in Target-2 balances, as it opened a door for capital flight. The banks were able to use risky bonds as collateral for fresh money and transfer this money to safer countries.

Three years later, a substantial part of these three-year loans has been repaid. This month sees the deadline for the last tranche of loans. This forms one reason why Target-2 balances could fall substantially in the near future, in particular in countries that made strong use of LTROs, such as Italy and Spain. Italy witnessed some capital flight last autumn, but reported a Target-2 improvement of €44bn in January.

Yet Greek uncertainty may drive Target-2 balances in the other direction. Greece’s Target-2 liabilities fell from a peak €109bn two years ago to only €30bn in summer 2014. Unlike Spain and Italy, this did not reflect a return of private capital. Rather it was a technical reaction to the bail-out-packages paid out to Greece via the Target-2 clearing platform. The apparent improvement in Greek balances was almost exactly aligned with inflows from the rescue packages. So it is no surprise that, in the weeks before the Greek election at the end of January, Target-2 balances started to worsen again.

This deterioration is linked to an important unresolved issue: national regulators and central banks have a strong incentive to classify banks as ‘illiquid’, rather than insolvent – one of the important original faults in the edifice of the euro.

Under the euro area's rules, banks can borrow from the ECB when they are solvent and have eligible collateral. A national central bank (or national regulator) that believes a bank may be on the brink of insolvency thus faces a significant dilemma. If the central bank classifies the private bank as insolvent, the full resolution cost will be passed on to the taxpayer in the country concerned.

If, on the other hand, it classifies the bank as solvent (although temporarily illiquid), potential losses on refinancing loans will be shared with the other countries. The potential losses will be based on countries’ share of the ECB’s equity (the so-called capital key). Thus there is an overwhelming incentive for the authorities to keep the bank open and provide further credit.

Given its new task as the foremost supervisory authority in Europe, the ECB now has the opportunity to escape this pernicious incentive structure by taking a much tougher line on declaring that banks are insolvent and not simply illiquid. This would mean that for some hard-hit parts of the euro banking system, the direct credit from national banks, under the emergency liquidity assistance provisions, would have to stop. This would bring a salutary decline in Target-2 balances and capital flight – and make monetary union a safer and more predictable system.

Frank Westermann, a member of the OMFIF Advisory Board, is professor of Economics and director of the Institute of Empirical Economic Research at Osnabrück University. For further details see Euro Crisis Monitor.